Market Strategists Usually Wrong When They Agree

Just when you thought it was safe to take stock market advice from experts comes this news from Merrill Lynch & Co.: The advice given by chief investment strategists - the top honchos when it comes to market calls - turns out to be a contrary indicator.

That’s a nice way of saying they’re usually wrong.

For the last 11 years, Richard Bernstein, the director of quantitative and equity derivatives research at Merrill Lynch in New York, has been following the predictions of top brokerages’ chief investment strategists, particularly their advice to customers on what proportion of their accounts to allocate to stocks, bonds and cash.

It turns out, says Bernstein, that when the investment strategists are most in agreement, they are usually wrong. If a clear majority of them agrees that it’s a dangerous time to be overloaded in stocks, it’s often a good time to buy. And if a clear majority agrees that stocks should be emphasized - as they did last spring - watch out.

“Where there’s unanimity, it’s time to do the other thing,” Bernstein says.

This should come as no surprise to people who study crowd psychology, says Bernstein. Investment strategists are extremely bright people, but even bright people have a tendency to fall into what he calls “groupthink.”

“In any group, that’s bound to happen - analysts, taxi drivers or a strategist, you’ll get herd instincts,” Bernstein says. “We search for the herd instinct.”

In the last 11 years, there have been seven times that the strategists were extremely pessimistic as a group about the market. Investors should have paid them no mind: Had they bought stocks at those times, they would have gained an average of 21.2 percent in the next year, Bernstein says.

Just after the October 1987 crash, for instance, the majority of investment strategists turned sour on the market, says Bernstein. In fact, it was a good time to buy: Stocks rose 18.8 percent in the next year.

“You get a buy signal when people get scared because the market goes down,” he says.

Bernstein quietly compiles information each month on what Wall Street strategists think and turns it into a small report that becomes part of Merrill Lynch’s forecasting. The fact that his reports are based on group psychology among his own peers doesn’t bother him: It’s just another form of the “sentiment indicators” analysts often use, he says.

Other sentiment indicators that are popular include the “bull and bear” poll, in which traders are asked if they are bullish or bearish, or the buying habits of small investors, which some believe are nearly always wrong.

But it’s one thing to measure the psychology of anonymous crowds and another to observe that your colleagues in the next offices are wrong, he acknowledges. A lot of delicacy and trust is required to gather the information.

Bernstein polls 15 analysts at the major brokerages - presumably including Merrill Lynch’s, though he won’t identify any of them - for his data, using the strategists’ asset-allocation models. (As part of their jobs, investment strategists construct an imaginary “balanced” portfolio consisting of stocks, bonds and cash. Each month they publish their ideal allocation. When the strategists are optimistic about the stock market, they might suggest keeping, say, 60 percent of the portfolio in stocks, reducing that to 50 percent when they’re pessimistic.)

Bernstein averages the allocations using a proprietary math formula and charts them against the market over time. In return for the information, he promises anonymity and copies of his studies, so the strategists can see where they stand among their peers.

So what are the strategists saying now?

Polled in late August, they suggested putting only 50.8 percent of a balanced fund in stocks - a sign of pessimism. If that number were to move just a little lower, says Bernstein, to 50.5 percent, that would suggest investors should do the opposite, and buy. If it were to suddenly rise above 57.2 percent in stocks, that would be a signal to sell, Bernstein says.

And why, besides herd instinct, are the strategists often wrong when they agree?

“It’s not that these guys are stupid,” says Bernstein, who is wary of his study being used for “Wall Street bashing.”

“It turns out that they time the bond market very well - extremely well. But the problem is, in their allocation, they seem to forget that stocks rise with bonds,” so that sometimes when they suggest adding more bonds to a portfolio at the expense of stocks, it looks like a bad stock call.

Also, he says, all stock market consensus is wrong for a logical reason. If everyone recommends stocks at once, stocks will likely rise in price, making them no longer such a good buy.